Carbon Footprinting: Helping Investors Ask the Right Questions

by | Aug 23, 2016

Lauren SmartLast year marked a turning point for the investment community in acting on carbon in their investments. By the time of the Paris Climate Summit in December, 110 investors representing over $10 trillion in assets under management had committed to reporting the carbon footprint of their funds on an annual basis,  and a further 25 had committed $600bn to being decarbonised as part of UNEPFI’s portfolio decarbonisation coalition.

Furthermore, we are beginning to see regulatory drivers such as Article 173 VI of the French Energy Transition Legislation which requires investors to not only report the carbon footprint of their portfolios but also to comment on the energy alignment in relation to internationally agreed targets. A key tool in helping investors has been portfolio carbon footprinting, an area which Trucost pioneered over a decade ago and which now has expanded to cover a whole range of carbon metrics and asset classes.

So what is carbon footprinting and how can it best be used?

Portfolio carbon footprinting captures the carbon exposure of a portfolio. For an equity portfolio this would essentially mean allocating the tonnes of carbon emitted by each underlying company to the portfolio on an equity ownership basis. This can then be compared to the fund’s benchmark and traditional portfolio attribution conducted to identify key areas of risk at a sector or stock level and identify areas for further exploration.

Portfolio carbon footprinting is particularly useful for pension funds who usually have thousands of holdings across many portfolios, with different benchmarks, geographic exposure and investment styles run by many different managers. The tool is highly valuable in synthesising this information, distilling it and identifying key areas of exposure for further analysis. It also becomes a valuable tool in manager engagement, helping to identify managers who may be running greater exposure than the benchmark and providing the evidence base from which to ask detailed questions of managers about how they are managing their exposure.

Some critics point to the fact that carbon footprints don’t provide all the answers. This is of course true – no single metric can provide all the information one may want to understand climate risk, opportunity and impact within a fund, in the same way that no single financial metric would tell us everything about the financial health and prospects of a company. A range of metrics is required, and so traditional carbon footprinting is being supplemented with additional layers of analysis and a broader range of carbon metrics depending on the question posed.

For example, for a forward looking assessment of the potential exposure to “stranded assets” that a company may face, an assessment of the exposure of a fund to fossil fuel reserves and the carbon embedded within them is required. For investors who wish to divest from coal, an assessment of the holding’s coal mining and production activities is required to determine which would trip the investor’s thresholds. For many investors, understanding the trend and direction of a company’s business mix between “brown activities” and “green activities” is a core piece of information to be layered on.

Likewise, to understand and communicate the positive green impact of a fund, a deeper assessment of the types of “green” activities is necessary, and ideally a quantification of the carbon savings per million dollars invested. These different metrics provide answers to different questions and, simple as it may sound, understanding what questions you seek to answer from your fund carbon analysis is vital in order to get the most out of it. Similarly, recognising what a fund footprint won’t tell you is equally important. Fund footprinting is a tool best used for top-down portfolio level assessment, and in order to understand how the valuation of a company may change to inform a bottom-up stock picking approach based on fundamental analysis, a detailed integration of monetized carbon costs, liabilities and opportunities needs to be built into the analyst’s discounted cash-flow model.

This layering of carbon metrics with traditional portfolio footprinting ultimately provides investors with a more holistic tool kit. But how a workman visualizes their end product and how they use their tools is what makes the difference between an outcome that is a cathedral or simply a lump of rock. What is most important is to know what you want to achieve, and what questions you seek to answer in your carbon assessment in order to select the most appropriate metrics. Are you interested in reporting positive impact as that is core to your fund’s investment thesis and marketing? Do you want to identify companies to divest from to minimise reputational or long-term stranded asset risk? Do you want to understand how carbon risk may be monetized and affect fair value over a two-year time frame? Do you simply want to communicate your fund’s exposure relative to the broader market for stakeholder communications? How do these questions align with your investment beliefs?

Frequently investors start the carbon journey without a full understanding of what questions they seek to answer, and frequently the questions may be different for different people within the financial institution – particularly as this is a new and evolving area of thought for many investors. In this case, traditional carbon footprinting is a valuable tool as a starting point to begin to understand and question your fund through a carbon lens, leading to further discussion internally and creating the necessary discussion to elucidate the longer term purpose. From personal experience, having presented carbon footprint results at many investment committee meetings, the role of carbon footprinting as a powerful tool to bring about these discussions cannot be underestimated.

As Faith Ward, Chief Responsible Investment and Risk Officer at the UK Environment Agency Pension Fund states: “The power of portfolio carbon footrprinting is in helping us ask the right questions, not in providing all the answers, and for this purpose it is highly valuable.” What is clearly beyond doubt is that investors are increasingly demanding analytics to understand their climate impact, risk and exposure, and that portfolio footprinting in its many evolving forms is an important part of this tool kit.

This story has been reprinted with permission from Trucost.

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